Master Limited Partnerships Solid, Stable Growth

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1 2012 Master Limited Partnerships Solid, Stable Growth Offices: New York: 520 Madison Avenue 26 th Floor New York, NY Palm Beach: 324 Royal Palm Way Suite 226 Palm Beach, FL Delaware: 200 Bellevue Parkway Suite 525 Wilmington, DE In the current uncertain market environment and as taxation of investment income comes under increasing political scrutiny master limited partnerships (MLPs) can offer an attractive alternative for investors. MLPs, which are chiefly engaged in natural resource businesses, combine solid, stable growth with the liquidity of publicly traded securities and the tax efficiency of standard limited partnerships (which do not pay state or federal income taxes at the partnership level). Over the past 15 years, MLPs have substantially outperformed common stocks while receiving extremely favorable tax treatment. To qualify for MLP status under the federal tax code, a partnership must generate at least 90 percent of its income from the production, processing or transportation of oil, natural gas and coal. MLPs pay their investors through quarterly distributions specified in the contract between the limited partners (the investors) and the general partner (the managers). Because the distribution amounts are set, the vast majority of MLPs are oil, gasoline or natural gas pipeline businesses earning stable income from relatively long-term contracts and stable rates (or tariffs) for intrastate or interstate transport of these resources. As natural resource companies develop new fields, the new pipelines and other infrastructure they engender also create more growth opportunities for MLPs. MLPs can also encompass other natural resource businesses such as exploration and production companies, field aggregation and processing facilities and storage terminals. Tax advantages Because MLPs are partnerships, they avoid corporate income tax at both the state and federal level. Unlike qualified dividends from corporations, which are taxed under the current tax code at 15%, the distributions are taxed as ordinary income at the marginal rate of the partner. However, because they qualify for accelerated depreciation and make ongoing capital investments, the tax code treats 80%-90% of the distribution, on average, as a return of capital, while counting only the remaining 10%-20% as a return on capital. 1

2 Even if the limited partner pays a 35% marginal rate, this formula results in an effective tax rate of 7% (20% taxed at 35%), less than half the 15% currently applied to dividend income. The return of capital portion lowers the limited partner s cost basis, and the LP pays these deferred taxes only upon sale of the MLP. However, if an MLP is held until death, the holder receives a step-up in tax basis and the tax deferral starts again. Chart 1: Total Returns Over 15 Years Return comparison The Alerian Index, which has tracked MLPs since January 2006, shows that MLPs have outperformed the S&P 500 Index by approximately 10% per year over the past 15 years, generating a compound rate of return of 16.4% which is more than two and one-half times the S&P s 6.2% (see Chart 1, above). As Table 1 shows, higher yield and higher dividend growth over time have primarily driven this outperformance while valuation changes have had a minor impact on the total return. By adding together dividend yield and dividend growth, what we call Total Return Sustainability, this measure was 13.7% for MLPs and 6.5% for the S&P 500. Table 1: Components of Return 2

3 Distribution growth To increase their dividend distributions, MLPs have historically relied on three factors: throughput growth, cost escalation and acquisitions. Organic increases in resource throughput and cost escalation each contribute 2-3% to distribution growth, while acquisitions add a further 2-3%, for an average of 6-9% growth in distributions. Moreover, as Chart 2 shows, MLPs have generated this growth with lower volatility than S&P 500 equities. Chart 2: Dividend Growth Comparison Throughput growth is primarily a function of production growth, which depends on field development and energy prices. Using an 80%/20% mix for natural gas versus oil production as a proxy for MLP throughput mix, Chart 3 shows a strong correlation between the year-over-year changes in production growth and distribution growth. Chart 3: Production versus Distribution Growth Although Chart 3 does not show this, oil and gas price drops fueled production growth declines in 1998, 2005/06 and However, while the 2008 credit crisis drove oil and natural gas prices down even more than in prior periods of decline, the growth in shale-related production has made up the difference. 3

4 Indeed, since 2009, oil production in the U.S. has been growing, instead of shrinking, for the first time in almost 25 years. Chart 4 shows supply projections by the Energy Information Administration (EIA) over the next 25 years, under which shale production rises from 23% of total supply in 2010 to 49% by The EIA expects natural gas production to grow about 1% per year over this period. At the current levels of natural gas consumption, the EIA estimates that the U.S. has over 90 years worth of shale gas supply alone. Chart 4: Natural Gas Production Estimates Conclusion In view of our outlook for below-normal global economic growth for the medium term, we view current yield and dividend growth as crucial for our clients portfolios. Since we expect MLPs to see high single digit to lower doubledigit returns over the next several years with a lower effective tax rate during the holding period we believe they can be an important component of a higher yielding investment strategy. Although we see a change in the tax code or energy policy as the greatest risk to the long-term attractiveness of LP structures, we see this risk as remote for MLPs since they are a much smaller asset class than private equity and hedge funds and they have a more retail-oriented investor base. 4

5 The Search for Yield Notes & Important Disclosures The information presented herein is intended as an illustration of the services offered by Tiedemann and such services may not be suitable for all individuals. This information does not constitute, and should not be construed as, the provision of tax, accounting or legal advice or investment recommendations. This information is intended to serve as the basis of discussion with a Tiedemann professional. All statistics, opinions or views expressed in this report are as of the date of the report unless indicated otherwise and are subject to change at any time without notice. The data and commentary presented in this report are for informational purposes only, are neither complete nor exact and are provided solely as reference material. Additional information is available upon request. Information given herein is believed to be reliable, but Tiedemann does not warrant its completeness or accuracy. Past performance is no guarantee of future results. Tiedemann can make no assurance that the investment objectives will be achieved. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Any advice concerning a federal tax issue in this communication, including any attachments, is not intended to be used, and cannot be used, for the purposes of (i) avoiding penalties imposed under the United States Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter discussed herein. Index Information: Index information is included for illustrative purposes only and is not intended to imply that the investment objectives are similar to any index in composition or in element of risk. Indices are unmanaged and generally do not reflect the reinvestment of income and dividends or the impact of advisory fees. 5